What Is Insurance?

Insurance is nothing more than a shared risk pool. One of the basic principles of insurance is that of risk sharing. The definition of risk sharing is nothing more than using strategies to mitigate the consequences of adverse events by spreading the potential burden across multiple stakeholders. 

The insured pays a premium in exchange for the insurer’s promise to cover the costs of certain losses, should they occur. This arrangement allows the insured to manage their financial exposure to risks, while the insurer pools the premiums from multiple policyholders to cover claims and maintain profitability.

Let’s start with life insurance, which is one of the easiest examples of risk sharing. You recognize that the cost of your funeral would be an unfair burden on others, so you want to purchase $10,000 in life insurance to help your loved ones out in the event that you die. The insurance company pools you together with people who have the same rough statistical chance of dying (using actuarial tables). Let’s say that those tables show that the chances of your death are 1 in 1,000 for any given year. This means that, in any given year, for every 1,000 people like you, the insurance company will pay out one policy. Now that they have the odds of payout, they have to calculate cost. Accounting for overhead, the insurance company will have to charge $12 in premiums to 1,000 people in order for $10,000 in coverage to be profitable for them. You are sharing the risk.

Now let’s assume that you are buying homeowner’s insurance in Florida. The company knows the chances of you having a fire, a flood, or a hurricane loss in any particular town. As we have seen with just the two examples (ISO and BCEGS), the insurance companies have REAMS of data that they use to calculate their odds of paying you. They then use their data to calculate the risk pool that your property falls into.

They use the ISO ratings of your area to determine the fire risk pool. They use the odds of a windstorm and the BCEGS rating of your community to determine the risk pool for natural hazards. They mitigate their exposure to liability due to criminal activity by excluding things like damage from police executing search warrants from coverage. Some natural disasters, like earthquakes, floods, landslides, and sinkholes, are often excluded from insurance coverage. (If there has been a sinkhole in the past 5 years that is within a mile of your house, no one will sell you a sinkhole policy) By the way, here is a listing of the ISO and BCEGS ratings (pdf warning) for all of Florida.

At the same time, the risk of a homeowner experiencing a theft are calculated, so are the risks of your dog biting someone, as well as every other risk they can think of. Even included is your credit score, because credit is a predictor of your likelihood of filing a claim versus just paying to fix it yourself. Poor people with bad credit are far more likely to file a claim than a well to do homeowner who doesn’t want his rates to rise for a small claim, so they just fix it themselves.

Each of these risk pools has its own set of risks and costs, and the insurance premiums are a reflection of that. Since each insurance company has its own set of criteria for predicting risk and loss, each company will have different rates. If you look closely at your policy, you will see that it doesn’t pay out for things like a terrorist attack, an act of war, a nuclear detonation, and any number of other things that the insurance company knows will result in too much risk.

If you don’t want to pay higher premiums because of hurricanes on the coast, you can always insure your house without hurricane coverage, called an x-wind policy, or just go without insurance. If your house is mortgaged though, good luck with that.

An x-wind policy is where the homeowner signs a paper declining coverage from windstorms. If the home has a mortgage or a lien, then the policyholder must also get a written statement from the lender or lienholder saying it approves the policyholder choosing to exclude windstorm coverage from the insurance policy. If you do choose to keep hurricane coverage, you will have to select what your hurricane deductible will be: $500, 2 percent, 5 percent, or 10 percent of the policy dwelling or structure limits. (some other restrictions apply- talk to your agent) Selecting higher deductibles means that you are assuming some of the risk for hurricane damage, which will result in lower premiums by placing you in a different risk pool. YMMV.